Why Doctors Need to Understand the Cashflow Quadrant

[Editor’s Note: The following is a republished post from Passive Income MD, a member of the WCI Network. This is the first post in a two-part series on the “cashflow quadrant.” This one explains what the cashflow quadrant is and the second goes into how doctors can apply the cashflow quadrant to achieve financial freedom. I’m not a huge fan of Kiyosaki, for reasons probably best expounded on by John T. Reed. But I’ve got to admit, I think the cashflow quadrant is a concept worthy of your time and understanding.]

I owe a lot to Robert Kiyosaki. His book, Rich Dad Poor Dad, actually helped start me on my path to financial freedom, and his other writings have all taught me very valuable lessons.

While I don’t agree with everything he says in every book, one thing that really cemented the idea of passive income in my mind was the concept of the “cashflow quadrant.”

This concept is so important and fundamental that I believe every doctor needs to read and understand it as much as possible (for more detail, check out his book, theCashflow Quadrant). But since none of us have much free time, let me break down a quick summary for you.

The Cashflow Quadrant

Using the concept of quadrants, Kiyosaki talks about different careers and how our current tax structure plays into them. He even talks about the mindsets of different careers and I think he’s pretty spot on.

In the book, Kiyosaki breaks it all down using four key areas (hence the quadrants) and labels them with a letter:

When it comes to jobs, careers, and business, some people fall into multiple “quadrants,” but everyone fits into at least one of these categories. To break it down even further, here are some details on what each of those categories means.

E – Employee

The majority of the population lives in this quadrant. An employee makes money by putting in their time and performing their job, and collects a wage or salary. Their income is tied to their time and they are essentially trading time for money. The only way to earn more money is to work more hours–or jump to another company that pays more per hour.

However, you’re still trading time for money even with a salary increase–if you don’t work, you don’t get paid. More and more, doctors are finding themselves in this quadrant as private practice continues to diminish. How many of you are employees of a large health system and paid a salary based on a set number of hours a week?

S – Self Employed

Self-employed people may feel like they’re in a better position than employees but are still essentially trading time for money. To make more, you still have to put in more hours. Kiyosaki states that for the self-employed, the business actually owns them.

As a self-employed physician, you might have a little more control over your time. But even so, if you don’t work you still won’t get paid. Furthermore, how much you get paid may or may not be under your control, depending on whether you accept insurance or not.

B – Business Owner

Being a business owner, in this sense, means that you own or run a system that produces income not proportional to the time you put in. You may have a large number of employees who work hard for you to help you build your business.

This is where the concept of scale comes in, and your income isn’t linked to your time. Because of this, your time becomes much more valuable. There are very few physicians who make it into this category, but some savvy entrepreneurial doctors have figured out a way to live in this space.

I – Investor

As an investor, your money works for you to create additional, passive income. Examples of these types of investments include stocks, real estate, royalties, and owning portions of businesses. From these investments, you’re able to receive the cash flow necessary to be financially free.

Active Income vs. Passive Income

Let’s look at the quadrants again. Another way to divide them is by the level of effort. The two quadrants on the left are considered active income. As an employee, or if you’re self-employed, you are actively trading your precious time for money. In short, time in = money out.

The two on the right are considered categories of passive income. With these quadrants, your income is not proportional to the time you put in–money is coming in even when you’re not actively working.

Quadrants and Uncle Sam

As a side note, it’s important to discuss taxes. Our current tax system is designed to favor the right side of the quadrant – Business Owners and Investors.

Using legal provisions in the tax code, you’re able to lower your effective tax rates. The Business quadrant in particular also causes the formation of jobs, which the government encourages using the tax code.

Unfortunately, there just aren’t as many tax breaks for the left side of the quadrant. That helps explain why so many highly-paid employees or self-employed doctors end up getting crushed when it comes to taxes.

Wrap Up

As doctors and high-income professionals, we’re taught one thing throughout our educational path: work hard and you’ll be appropriately compensated. Unfortunately, as many of us have discovered, that doesn’t necessarily sit true in the real world.

I receive tons of emails from physicians saying the same thing: “I’ve reached what I believe is the pinnacle of my career, and worked so hard to get here. Why, then, do I feel like I just can’t get ahead?”

Well, taking a deep look at the cash flow quadrant and realizing which one you’re in can help explain a lot. As physicians, our goal should be getting on that right side.

It doesn’t necessarily mean leaving medicine, but it does mean building additional streams of income and investing smartly, ultimately making it so that your income isn’t dependent on your time in the hospital. The last thing we want is to be a well-paid hourly worker with a huge tax burden.

As high-income professionals, we have a unique opportunity. With smart spending and strategic investing and savings, we can quickly move to the right side of the diagram–specifically, the Investor square, where true financial freedom is found. It doesn’t need to take forever, either. In fact, the White Coat Investor and Physician on Fire believe that most of us can get there in about 10 years after training.

In the next post, we’ll go into further detail on some of the ways to move to the right side of the cashflow quadrant and move towards financial freedom.

Which side of the cashflow quadrant do you sit mostly on?

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The right 2 quadrants are definitely the ones to aim for. The only caveat about the tax advantages in the investor quadrant is that not all passive income streams are tax advantages. Dividends from REITS or rent distributions from property (whether syndication or crowdfunding) are taxed at your individual income tax rate. It’s the qualified dividends from passive income sources that get a major tax break (22% or so off the highest tax bracket)

The beauty with real estate is depreciation. This will largely offset your income from the property. I do accelerated depreciation on several properties I own not only does it offset the income it will show a loss which I can then use to offset my passive farm income.

The left side of the chart is taxed the highest. This makes it harder to get ahead than the same money that flows in from the right side of the chart. The more you move to the right, the more of the money your earned, you will actually get to keep. This is one of the factors against being an employed physician. It is the most taxed path a doctor can take. If an employed physician and an independent physician make the same income, the employed physician will keep less of it. Do what you can to move to the right.

Not true. The self-employed doc has to pay both halves of the SS tax and for her own benefits. If you become an independent contractor, you need to make sure you’re getting paid enough more than you were paid as an employee to make up for those two major expenses. The tax deductions for a typical doc won’t make up for those two factors unless the employer benefit package was terrible.

This matrix is helpful. It occurs to me that the logic can be extended within the I quadrant for purposes of planning drawdowns in retirement. Specifically if one considers that different investment vehicles have different taxable characteristics, that should inform investment allocations (I.e., taxable, 401k, 403b, 457, rabbi trust, etc.) Advisors like WCI implicitly do this with their guidance on which order to fill the buckets and then in which order to empty them. Maybe this is not profound, but it has me reconsidering my retirement drawdown plan.

Ok, I get that you have to make the disclaimer, but then again it’s all over the website. For the record, I did not mean to imply that you were a licensed financial advisor. Has anyone ever actually tried to hold you legally accountable for the content of your blogs?

The part that is left out of the quadrant (and, frankly Kiyosaki’s writings in general, for obvious reasons) is the tradeoff between risk and reward. A business owner has the potential reward of mutiplicative profits from employees, but they also run the risk of being obligated to pay those employees without enough revenue to do so and not only not being compensated adequately for their work, but for losing their investment entirely. Investors run the same risks at arm’s length.

This doesn’t mean, of course, that nobody should take those risks. It just means that Kiyosaki is, above all, a shill, and the message of “just shake off your old mindset and follow my guide and all will be sunshine and roses” sells a lot better than “take big risks and you’ll may lose everything, but maybe not.”

Pulmdoc,
The employee is not without risk. Since someone else is in control, the employee risks being fired, being asked to do something they don’t agree with, risk of losing benefits at someone else’s discresion……

Yes, employees can be laid off if the company goes belly-up. However, whatever money they were paid for their services is theirs. There is no chance of a negative return on time invested, assuming the first paycheck didn’t bounce. The same cannot be said of the people who put their capital into the business.

I agree with both pulmdoc’s criticism of Kiyosaki and your point about employee risk. I think about that often when I consider my partnership’s entire business is dependent on a single contract with the hospital.

Kiyosaki sure is a schuckster who’s never without a big marker. Always feel like taking a shower after watching him. My apologies if it’s off topic, but I don’t put much weight in his advice or the boxes and arrows he draws.

Not sure where pension income fits in….Employee? but it’s passive (should be on right side). it’s not tax advantaged passive income and its not income generated from an investment (but obviously you can invest the pension money which is what we do), Even though not tax advantaged, i’m not sure i hear anyone complaining about collecting a pension for nearly 30-40 years…..our neighbor collected his for 56 years until he died at age 99…and now his wife collects it and she is now 98……to boot when he started collecting his pension in 1960, then he started working for the post office and ended up collecting that pension too for 30 years on top of the other one …. my husband has been collecting his for 10 already……. i could stand corrected to say that it may be tax advantaged, military pensions are non-taxable the portion which is offset by VA disability. If one is 50% or more disabled rating, then that compensation (non-taxable) is stacked on top of the taxable pension…so partially tax advantaged (tax-free) for some people, if their VA compensation is <50%.

I have worked hard my whole life in quadrants E, S, And B….Now I work most hard in quadrant “I” since I am sick of getting crushed by taxes and the government. Our tax code sucks. Amazing that with all of my education, intelligence and hard work that I now work hardest at avoiding taxes.

Also, I’m pretty sure you forgot a quadrant: D (disability)…..some people work VERY hard at this box. Unfortunately most of us have seen them in our clinic…..but I digress.

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